The income effect
The income effect is the impact that change in real income has on quantity demanded of a good. Let’s suppose our good is cheese. If the price of cheese in declined, then the purchasing power or real income is of anyone who purchases it increases. The increase in real income is reflected in increased purchase of normal goods, in our case cheese. For example, with a monthly income of 100$ you can guy 2 kg of cheese which worth 50 $/kg. If the price decreases to 25$ your purchasing power will increase so you’ll be able to buy already 4kg. A decline in price of the cheese increases consumers’ real income, enabling them to buy more amount of this good. This relationship is known as income effect.
Substitution effect is the impact that a change in a product’s price has on its quantity demanded. When the price of the good decreases, the product becomes relative cheaper to other products, so that consumers will try to substitute it for items that became now relatively more expensive. Lower price increase the relative attractiveness of a product, so that the consumers buys more of it. This relationship is called substitution effect.
The income and substitution effects combined increase consumers’ willingness and ability to buy a good when its price falls.
Law of diminishing Marginal Utility
This law is another explanation of downward-sloping demand curve. Although consumer wants are unlimited, wants for particular goods can be satisfied. More of a product people can obtain the less additional product they want.
Let’s take an example: When you don’t have an iPhone, your desire for it can be very strong, but the desire for a second iPhone is less intense and for the third, fourth and so on is weaker and weaker. So, the demanders will buy an additional unit of good only if price of that good or service will fall. So the consumer will spend his/her money rather on goods that provides the same or bigger amount of utility than on that which offer less utility. Thus, marginal utility provides the idea that price must decrease for quantity demanded to increase. We can also state that, if successive unit provide a sharp decrease in MU then demand for this good or service is elastic. Conversely, slow declines in MU imply that demand is inelastic. We can state Law of diminishing Marginal Utility as follows – as consumer increase consumption of a good or service then the marginal utility obtained from each additional unit will decrease.
Utility is the want-satisfying power of an item or a service; the pleasure consumers take from keeping or using that good or service. “Utility” and “usefulness” is not the same, for example paintings of Leonardo da Vinci may offer utility for art lovers but they are useless in functionality. Also utility is something subjective, for example an old wrist watch can offer great amount of utility for a collector, but for someone else it may not have such a great utility.
Now we must make a difference between two important economic terms: TU (total utility) and MU (marginal utility). Total utility is the total amount of satisfaction a consumer can get from a specific quantity (example 5, 20, 100) of goods or services. In contrast, Marginal utility is pleasure taken from consuming each additional unit of good or service (also equal to Total utility divided by quantity of good consumed).